Modelling emerging market risk premia using higher moments

Abstract

The purpose of this paper is to assess the incremental value of higher moments in modelling capital asset pricing models (CAPMs) of emerging markets. Whilst it is recognized that emerging markets are unlikely to yield sensible results in a mean‐variance world, the high skewness and kurtosis present in emerging markets returns make our assessment potentially interesting. Generalized method of moments (GMM) is used for the estimation. We also present new versions of higher‐moment market models of the data‐generating process of the individual emerging markets and use these to identify model parameters. We find some evidence that emerging markets are better explained with additional systematic risks, such as co‐skewness and co‐kurtosis, than the conventional mean‐variance CAPM. Copyright © 1999 John Wiley & Sons, Ltd.

Testing conditional asset pricing models: An emerging market perspective

“…Kurtosis is especially useful in the case of emerging markets which are characterised by high frequency of extreme observations in either direction of the return distribution suggesting thick tails relative to normal distribution. For example, Iqbal et al (2010) for Pakistani market and Hwang and Satchell (1999) for a group of emerging markets demonstrate that kurtosis is an important factor in modelling emerging market returns. Dittmar (2002) captures kurtosis by including a cubic aggregate wealth term in the pricing kernel.…”

“…The higher order co-moment literature provides evidence that kurtosis is more relevant than skewness for emerging markets. See for example, Hwang and Satchell (1999). The cubic market return is consistent with co-kurtosis as a pricing factor.…”

Increasing outer risk

“…3 For example, Harris and Kucukozmen (2001) employ the exponential generalized beta and the skewed generalized t distributions to study stock returns in the Istanbul Stock Exchange; Hwang and Satchell (1999) use generalized method of moments (GMM) to estimate the incremental value of higher moments in modeling capital asset pricing models (CAPMs) of emerging markets; Corrado and Su (1996) adapt a Gram-Charlier series expansion of the normal density function to provide skewness and kurtosis adjustment terms for the Black-Scholes formula for option prices and find significant skewness and kurtosis in S&P 500 stock index returns. risk aversion, for Kimball's (1993) decreasing absolute prudence, and for Gollier and Pratt's (1996) risk vulnerability.…”

Distributional asymmetry of loadings on market co-moments

“…Most applications use traditional time series regression methods based on OLS or GMM (e.g. Hwang and Satchell, 1999;Harvey and Siddique, 2000;Dittmar, 2002;Galagedera et al, 2003;Ranaldo and Favre, 2003;Chiao et al, 2003;Hung et al, 2004;Carvalhal da Silva, 2005;Smith, 2007;Post et al, 2008;Yang and Chen, 2009;Potì and Wang, 2010).…”